Why Biotech Investing Is So Hard

“A prince who will not undergo the difficulty of understanding must undergo the danger of trusting.”
– George Savile

While the healthcare industry – Health Care SPDR (NYSE:XLV) — on average is considered to be a low beta, less cyclical area of the stock market to park money when an investor is concerned about an economic slowdown, the biotechnology industry – SPDR S&P Biotech Index ETF (NYSE:XBI) — within healthcare is seen as an aggressive play on speculative companies.

The reason for this has to do with the nature of biotech companies, which tend to rise and fall on drug trials and regulatory approvals. Many such companies have no growth or products to speak of but rather drugs in the pipeline that could become blockbusters.

Because of this, it’s a very difficult area to chase momentum in. After all, the broader healthcare sector tends to really outperform only in highly volatile periods for equities overall, and the industry seems to be much more vulnerable to company-specific risk than many others.

Take a look below at the price ratio of the XBI relative to the S&P 500 (NYSE:IVV). As a reminder, a rising price ratio means the numerator/XBI is outperforming (up more/down less) the denominator/IVV.
Click to Enlarge

I’ve included several trend lines which are quite steep both up and down. When biotech outperforms, it tends to do so in a very spikey and less trend-oriented way than other areas of the market. When underperforming, biotech tends to collapse very quickly.

The implication of this is that an investing strategy designed to take advantage of momentum and alpha generation based on technical patterns and crowd herding is extremely difficult because of the speed at which the industry leads and lags. For more strategy-oriented investors then, biotech is an industry to avoid.